CHAPTER FIVE 5
Impairment Testing
TESTING FOR THE IMPAIRMENT of assets (both tangible and intangible) is not only a generally accepted accounting principle (GAAP) requirement but absolutely essential in terms of internal control. It is critical that the real value of assets never be overstated. Keeping overvalued assets on the balance sheet misleads management, not to mention outside users of financial statements such as creditors and investors. Yet, as will be seen, there is often great reluctance to recognize impairment charges when they are required by GAAP and internal control.
The reason is simple. All impairment charges (with the possible exception of valuations of certain financial instruments which are not covered in this book) result in a charge to expense, which leads to a reduction in reported net income. We have yet to meet a CFO who wants to report less income to creditors and shareholders, disregarding for the moment the impact of impairment charges on taxable income and hence income taxes payable.
As a generalization while GAAP requires impairment testing at least annually, relatively few such charges made for financial statements have any effect on taxable income. So, in a sense, impairment charges when required and taken represent “All Pain, No Gain.” Nonetheless, no matter how painful, impairment testing is required and unfortunate results, no matter how unexpected, must be reflected in audited financial statements.
Controllers and CFOs, as well as CEOs and audit committees, should understand the methodology used in the development of impairment valuations. At times it is possible to anticipate future impairment charges-this does not make the pain go away but at least precludes surprises.
Impairment testing, often considered routine, is actually far from simple. To start with, there are in practice three separate impairment testing approaches required by GAAP. They must be performed in the proper order. Further, impairment testing is almost always carefully reviewed by outside auditors, and for public companies, often by the Securities and Exchange Commission (SEC).
Impairment must be tested at least once a year for all values shown at current or fair value. Further, the Financial Accounting Standards Board (FASB) also requires additional impairment testing of Property, Plant, and Equipment (PP&E) as and when what they refer to as “impairment indicators” are present. Impairment indicators, as laid out in FASB Codification Topic 360-10, really are little more than common sense. In theory, you do not have to test PP&E unless there is a reason that suggests impairment is possible. While we show the actual rules below, the best way to think of it, is “I know it when I see it.” Put another way, “If you think that some of your PP&E may be impaired, it probably is.”
The following is the portion of GAAP that specifically spells out the circumstances when an impairment may be indicated, with our [comments] and emphases appended:
“When to Test a Long-Lived Asset for Recoverability
35-21 A long-lived asset (asset group) shall be tested for recoverability whenever events or changes in circumstances indicate that its carrying amount may not be recoverable. The following are examples of such events or changes in circumstances:
a. A significant decrease in the market price of a long-lived asset (asset group) [Rare]
b. A significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition [Relatively rare]
c. A significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator [Common]
d. An accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group) [Very rare]
e. A current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group) [Common]
f. A current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. The term more likely than not refers to a level of likelihood that is more than 50%. [Infrequent]
35-22 When a long-lived asset (asset group) is tested for recoverability, it also may be necessary to review depreciation estimates and method as required by Topic 250 or the amortization period as required by Topic 350. Paragraphs 250-10-45-17 through 45-20 and 250-10-50-4 address the accounting for changes in estimates, including changes in the method of depreciation, amortization, and depletion.”
For internal control to be effective a procedure must be in place to test PP&E for impairment as necessary. Remember that all intangible assets and goodwill do have to be tested each year, while for PP&E it need not be done to a specific schedule. It is easy to list the above impairment indicators in a policy manual, but determining when actually to apply one or more requires management judgment.
Based on our roughly ten years of experience with impairment testing, by far the most common reasons to make a positive determination that impairment exists relates to current or projected operating losses, often caused by “a significant adverse change in the business climate.” In practice, in preparing a budget or forecast, see if losses are anticipated. Such anticipated losses may be caused by, or exacerbated by, excess carrying amounts for PP&E. In turn, this would call for formal impairment testing.
TESTING INTANGIBLE ASSETS THAT ARE NOT AMORTIZED
The easiest impairment test is that required by Topic 350, Intangibles. If an intangible asset (such as a trade name or Federal Communications Commission (FCC) license) is not being amortized, its life is considered indefinite. Indefinite life assets must be valued every year, and the test is to determine its current fair value. If the currently determined fair value is less than the amount on the books, an impairment charge is taken to reduce the carrying value to the new fair value which had just been developed. If the currently determined fair value is equal to, or greater than, the current carrying amount, then no impairment is present and nothing can be done. Although rare, we occasionally have a company which desires to take an impairment charge, but this is prohibited unless the test of current fair value is made and the fair value is below the book value. In other words, “voluntary” impairments are forbidden.
By the same token, one is not allowed to write-up the intangible asset to the new value. Impairment testing under U.S. GAAP is a one-way street. Sometimes this is referred to as the “roach motel” approach. Recall the old advertisement where the roach could get in but never get out. Similarly you can take an impairment charge, but never get out and reverse the expense charge if things have improved, at least back up to the original value. Interestingly, under International Financial Reporting Standards (IFRS) such write-ups are permitted. So, if the United States were to adopt IFRS, this is one of the major changes that would take place.
The impairment test for indefinite life assets, that is, seeing what the current estimate is of the fair value of the asset, requires a valuation of that specific asset. What is the proper methodology for this test?
Inasmuch as every intangible appears on the balance sheet as a consequence of a previous business combination, it is recommended that the same valuation methodology be used currently as was originally used. In other words, while there is often more than one way to value an asset, companies should not pick and choose one method over another just because it might provide a better answer. Auditors do check for consistency in valuation; companies and their valuation advisors should be careful, and first, go back and obtain the original analysis and then be sure to use the same approach. There may be circumstances where the original technique is no longer applicable, but any such change should be well documented.
It should be noted that in practice there are very few intangible assets that are not being amortized. The primary asset class in this category is trade names, sometimes called brand names. Many brands have histories in excess of 100 years (e.g., Budweiser) and it would be ridiculous to start amortizing such an asset on the premise that it loses value as it gets older. Well-established brands actually increase in value over time, as long as marketing efforts are continued. For PP&E, where value is often a function of age and usage, there are few examples of values increasing over time.
For trade names, however, the more it is advertised and marketed, the higher the probability it is likely to increase in value. Hence the FASB, in setting up testing rules for intangible assets, recognized this economic reality. Consequently, GAAP does not require amortization of trade name values. The downside to not amortizing a trade name, however, can come if the company decides to either cease using it, or puts primary emphasis on a different brand and sales of the original product start to decline.
Companies should only assign an indefinite life to trade names that they are absolutely sure will be continued, short of an economic catastrophe. Good brand names do go on seemingly forever, but weaker brands tend to fall by the wayside. We have seen numerous situations where a large portion of the purchase price of a company is assigned to the acquired trade name, and no amortization is required or taken. Subsequently, the company realizes it makes little economic sense to try and maintain two separate brand names for the same or similar products or services. A rationalization of marketing expense results in the acquired brand being downgraded or eliminated. The next time the brand name is tested for impairment, lo and behold there is now a very large and perhaps unexpected charge required.
As a result of this experience many companies are now electing not to treat brand names or trade names as having an indefinite life. Rather they assign a long (20 to 30 years) life and take a small annual amortization charge each year. With a 20-year life this would require 5% of the original value to be written off each year, while a 30-year life would require 3.33% as an annual expense. The advantage of this certain, albeit relatively long, life is that the impairment testing no longer is based on current fair value. Rather the testing for amortizable intangibles, and PP&E, is governed by Topic 360. As we will see, this test is truly unique in the annals of financial analysis. This amortization approach has the effect of writing down the reported fair value of the brand, so amortization can only be recommended where there is a significant possibility that the brand will be discontinued or downgraded.
TESTING FOR IMPAIRMENT OF PROPERTY, PLANT, AND EQUIPMENT, AND AMORTIZABLE INTANGIBLES
In the 1980s many companies took impairment charges seemingly at will, often to “clear the decks” when new management came in. Other companies, seemingly with losses, refused to take any impairment charges and told their auditors “show me where it says I have to take an impairment charge.” Of course, with nothing in GAAP directly on target, there was nothing the auditors could point to. Recognizing this as a problem, the FASB stepped into this vacuum and determined that a standardized approach to impairment testing was needed and that they would provide it.
While few corporate financial officers could object to a standardized approach to impairment testing, there was still great fear that FASB would move to adopt the dreaded fair value accounting so beloved of many academics and security analysts. If the FASB put in an impairment test that resulted in numerous charges, in each case writing the asset down to its then current fair value, this was perceived as a giant step toward full fair value accounting.
Under such a fair value accounting regime, net income would be calculated as the difference between beginning-of-the-year equity and end-of-the-year equity. It is not necessary to go into the problems such a system would cause; suffice it to say that at least theoretically FASB still prefers this approach. So far, the fears have not been realized and among the many reasons for this is that there are not enough valuation specialists in the world to determine the fair value all corporate assets every year, much less every quarter.
So fair value accounting is not currently on the horizon. But because of fears that it might be coming, in order to dispel unnecessary concerns among its constituents, FASB developed a unique valuation method of determining impairment through the use of undiscounted future cash flows. As long as the sum of the future cash flows is greater than the carrying or book value of the asset, or group of assets, by definition there is no impairment charge.
At the public hearings prior to adoption of what was then Statement of Financial Accounting Standards (SFAS) 121 (superseded by SFAS 144), the author was one of the people testifying. I told them that while I understood this undiscounted cash flow test, no client had ever asked me for that information. Fifteen years later, still no client has ever asked for an analysis of undiscounted cash flows, other than in the context of impairment testing.
The actual test is very easy to describe. You add up all the future cash flows and compare the total to the carrying value of the asset. As long as the sum of the future cash flows exceeds the carrying value, the company “passes” the test and no impairment charge has to be taken, or even can be taken voluntarily. The question immediately arises, “Well, ok, I understand, but how far into the future do I keep on estimating cash flows?” As long as the asset was deriving even $1.00 a year of positive cash flows, if you carried the test long enough every asset would “pass.”
Needless to say, the FASB understood this just as clearly as did any of their constituents. The rule now in place is simple common sense: carry out the projection for the period of time equal to the major asset in the group. So if you have a building with a remaining 26-year life, you can add up the next 26 years of expected cash flows. If you have a patent with but three years remaining then you can carry out the analysis for only three years.
The more difficult part of the analysis is determining what should be the correct measure of future cash flows. The impairment test is applied only to specific assets or groups of assets, not to a business as a whole. A company may have many different product lines, and many production facilities, with lots of interactions between and among them. The rule is easier to state than to apply:
“Determine the lowest level at which specific cash flows can be identified.”
It sounds simple and straightforward, but in practice reasonable people can, and do, differ in interpreting the rule. Let us start with an easy example. You have a production line with a half dozen discrete machine tools. Virtually every piece made requires operations on two or more of the tools. Five out of six of the machines are relatively new, but there is an older lathe which is nearing the end of its useful life and requires constant maintenance, even though it still carries a substantial book value. Common sense says that the value of the lathe is undoubtedly less than book value and that therefore “it is obvious we have an impairment and should write down the carrying value of the lathe to its current fair value.”
Here is a situation where the given rules give an incorrect answer, and it would be far better to have a principle that simply states “write down assets to their current fair value.” But GAAP is based on rules, and the rule quoted above calls for specific cash flows to be identified. It is impractical to determine what cash flows (cash receipts from the sales of the products produced on the production line) are attributable to the lathe and what remainder of the cash flows is attributable to the remaining five pieces of equipment. We can determine the total cash flows, and the total book value of the line, but we cannot determine the cash flows attributable solely to the lathe. Hence, there would not be an impairment charge to write down the lathe to fair value.
The other end of the spectrum is easy. You have an office building in a depressed economic area. No matter how you look at it the future net cash flows (after out-of-pocket expenses like taxes, insurance, and maintenance) sum up to less than the carrying amount of that building. You then write down the building on your books, taking an impairment charge to bring the new carrying value to the current fair value of the building.
The more usual, and more complex, problems arise when there are multiple products and multiple facilities. In effect, what is called for is a sophisticated cost accounting analysis that helps determine a net cash flow, which can then be summed up over future years. It is beyond the scope of this book to provide cost accounting guidance. What can be stated is that a reasonable attempt at identifying cash flows related to a reasonable grouping of assets is all that companies should strive for and that auditors should review. Anyone who has dealt with cost allocations and cost accounting knows that precision (beloved of auditors, unfortunately) is not possible. There are many ways to allocate costs, and different allocations will produce somewhat different answers. Pick a reasonable one, and let the consequences fall out.
Based on a lot of experience in this area, it is a safe generalization that while impairment testing is often required, the number of actual impairment charges based on Accounting Standards Codification (ASC) 360 is relatively few. The reason is that the FASB’s fear of causing too many charges, which led them to develop this undiscounted cash flow approach, has in practice worked out the way they expected. There are relatively few impairment charges, even though common sense sometimes suggests otherwise.
REVIEWING LIVES FOR ASSETS ALREADY IN SERVICE
This segment of the chapter deals with the situation discussed in ASC 360-35-22 (aforementioned), which covers the lives and future depreciation charges for assets already on the books but not yet fully depreciated.
A very simple example, one that in fact requires good internal controls, is the situation of an acquired trade name. Many companies plan to continue to use the trade name they acquired in a business combination. The rules permit trade names to be assigned an indefinite life, which results in no annual amortization charges but does require annual impairment testing. The test, of course, is to determine the fair value of the trade name or brand as of the annual testing date.
What frequently happens is that soon after buying a brand, as part of the total acquisition, the company decides to downplay the acquired brand and concentrate marketing resources on its existing brands. What then happens is that without continued marketing support, the fair value of the acquired brand starts to decline, resulting in an unfortunate impairment charge.
If the brand had been assigned a long but finite life, say 30 years, there would have to be annual amortization charges of just over 3% a year of whatever amount was assigned to the brand. But once a definite life has been assigned, the impairment test changes.
In this case the company first has to determine the current fair value of the asset (brand name in this example). Then an impairment charge is taken, assuming the current fair value is below the amount originally assigned. Finally, a new and definite life is assigned and amortization commences from that point forward. Subsequent annual impairment testing is then done on the brand name on an undiscounted cash flow basis. As long as there are still some sales of product under the acquired trade name the chances are very good that there will be no further impairment charges.
If, however, the company did not change the life, and kept it at indefinite, then it is likely that the fair value would decline year by year and it would be necessary to have repeated impairment charges. Shareholders and creditors can understand a single impairment charge, one year, because nobody and no company bats 1.000. But repeated impairment charges in succeeding years for the same asset will lead to embarrassing questions.
TESTING FOR GOODWILL
At this point we have looked at two of the three separate impairment tests called for in GAAP. Remember, these tests should be performed in the following order:
1. Testing the Fair Value of Intangible—Assets that are not being amortized (Topic 350).
2. Testing of Property, Plant, and Equipment, and using the same methodology testing of intangible assets that are being amortized (Topic 360).
3. Testing of Goodwill.
It is now time for the most difficult, and often most painful. The American Institute of Certified Public Accountants (AICPA) is developing a practice aid on impairment that might be available at the time this chapter is being read. The practice aid goes into a lot more detail than we can possibly cover in this chapter, and for answers to very specific questions the practice aid1 will be a very good source.
The following are the required steps, and each of them is discussed in order:
Step 1. Determine Reporting Units
Step 2. See if Reporting Unit has goodwill
Step 3. If no goodwill is present in a Reporting Unit, go on to the next Reporting Unit
Step 4. If the Reporting Unit has goodwill, then determine the fair value of the Reporting Unit
Step 5. If the fair value of the Reporting Unit is equal to or greater than the book value of the Reporting Unit, by definition there is no impairment and you stop
Step 6. If the fair value is less than the carrying amount or book value, you then must go to Phase II
Step 7. Phase II is equivalent to a full-scale allocation of purchase price, to be performed in accordance with the rules of ASC 805, using the fair value (as determined in Step 4 as equivalent to the purchase price)
Step 8. Add up the new fair values of all the identifiable assets in the Reporting Unit, subtract the sum from the fair value of the Reporting Unit
Step 9. The difference is now the new “implied” goodwill, which is then compared to the actual goodwill. If the old goodwill on the books is higher than the new implied goodwill, you must write the goodwill on the books down to the new level, resulting in an impairment charge
REPORTING UNITS
In developing ASC 350 which covers impairment testing (formerly SFAS 142) the FASB developed a new concept, called a Reporting Unit. The definition given is:
“The level of reporting at which goodwill is tested for impairment. A Reporting Unit is an operating segment or one level below an operating segment (also known as a component).”
After reading the above definition a couple of times, it may still not be clear what they are getting at. What it boils down to is that a reporting unit is the same as a segment of the business for which the company has to report sales, operating profit, assets, and so forth. Or, if the segment itself has lower-level businesses for which complete financial statements are available, then that lower-level unit is considered a reporting unit.
The importance of the reporting unit lies in the fact that the company, or its valuation specialist, must determine the fair value of that unit on the impairment testing date, which has to be at the same point each year (e.g., at the end of the third quarter). Thus, to be able to determine the fair value, it is necessary that financial information must be available that is comparable in scope to financial statements issued by publicly traded companies. As noted previously, if a reporting unit does not have goodwill, you do not have to determine its fair value. By the same token, if it does have goodwill on its balance sheet, you must determine the fair value of the reporting unit.
DETERMINING THE FAIR VALUE OF A REPORTING UNIT
The easiest way to develop the fair value of a small publicly traded business is to look at the latest stock price, and multiply it by the number of outstanding shares. This gives what is known as the market capitalization. If you add to that amount the outstanding debt (not current liabilities, but bank debt and other long-term interest-bearing obligations), you have the business enterprise value (BEV).
The rule is that in Phase I you first have to compare the fair value of the unit to its carrying amount. If the fair value is greater than the carrying amount, you stop. By definition there is no impairment. Only if the fair value is less than the carrying amount do you go to Phase II; this involves essentially a revaluation of all assets in the reporting unit at today’s fair value.
To meet the Phase I of ASC 805, the market capitalization (fair value of common stock alone) has to be greater than the book value of the equity. If it is larger, one stops because the company has passed the test and by definition in GAAP there is no impairment of goodwill. Under current rules, the test should probably be done at the equity level, not the BEV level (which includes outstanding debt).
It is obvious that this test, for a publicly traded company, is totally dependent on the current market price of the stock, in relation to the book value, defined as the dollar amount of equity on the balance sheet. In 2008-2009, when the market reached new lows not seen for many years, a large number of companies had to take impairment charges for goodwill, no matter how loudly they argued that “the current [low] price of our stock is only temporary” or “the current price of our stock does not reflect our value” or “our Board believes the current price of our stock is way underpriced.”
As it turned out, of course, all of the above three arguments were correct. Stock prices rebounded. Unfortunately, under GAAP, once an impairment charge is taken it cannot subsequently be reversed no matter how well the stock price behaves. Interestingly, under IFRS, such reversals are sometimes possible.
But how do we perform the test for a reporting unit of a company which by itself is not traded publicly, or for any privately held company with no stock price that can be looked up in The Wall Street Journal? This becomes the domain of valuation specialists (the author in the light of full disclosure does perform this task).
Inasmuch as entire books have been written as to how to value a business, we can only outline here what appraisers do, not tell readers enough for them to “do-it-yourself.”
Appraisers generally value businesses, or units of a larger business, using two separate and distinct methodologies. The first is a discounted cash flow (DCF) approach and the second is often referred to as a market comparable approach. A DCF analysis relies on projections of future operating results, while the market comparable approach looks at what other “comparable” companies actually trade at in the market.
When companies are afraid they may not pass Phase I, and want to avoid an impairment charge, we often see very optimistic sales and profit forecasts. The reason is clear, if the company predicts great cash flows over the next five years, the present value of the company will be high. And if the present value is high the company passes the test! No wonder company managements sometimes appear to be extremely optimistic.
From the perspective of an independent appraiser, and the company’s own auditors, it is hard to argue with an optimistic forecast prepared by management, even if there is a suspicion that the optimism is really based on a desire to avoid impairment. All that can be said, in effect, to that management is “Well, you are pretty optimistic, and we hope you make it. But if you do not achieve these projections, then next year we will have to scrutinize your projections much more closely.” Sometimes companies can dodge the impairment bullet for two years with optimistic forecasts that boost the value of the company under a DCF methodology. Inevitably, the third year comes around and the audit firm, fearing the wrath of the Public Company Accounting Oversight Board (PCAOB) and SEC will not accept continuing projections that are not met.
While there is some scope for “judgment” in the DCF approach to valuation, when appraisers use the market comparable method, the client is really going to be at the mercy of the stock market. This is because the prices of the stock of most companies in a particular industry go up and down more or less at the same time. Thus, a privately held chemical company is going to have a much lower value when chemical company stocks are selling at a price-earnings (P/E) level of seven to eight times compared to better times when most of the chemical companies trade at a P/E of 13 to 14 times.
The Phase I test for goodwill impairment effectively values a company at a single point in time, and does not evaluate future trends. Sharp rises and falls in stock prices, up to ten percent or more in a single day, lead many observers to challenge the underlying logic of the FASB approach. But the rules are in place and there is virtually no flexibility in their application, as many companies found out in 2008-2009.
PHASE II TEST OF ACCOUNTING STANDARDS CODIFICATION 350
Remember, the impairment testing required by ASC 350 is truly binary. You either pass the test and then immediately stop, or you fail the test. In that case you must to go the next step, referred to as Phase II. Phase II is far from trivial, or inexpensive. Essentially, the valuation specialist (auditors usually preclude a client from doing this itself) performs a complete purchase price allocation, using the new BEV as equivalent to a purchase price.
The surprise result is often that there will be identifiable intangible assets in the reporting unit that had never been recognized before on the balance sheet. So if an acquisition were originally placed in a reporting unit that had several valuable trade names, the values of those trade names would not be on the balance sheet since companies cannot capitalize self-developed intangibles. If the reporting unit flunks Phase I, then in the process of performing Phase II the appraiser must value all of the brand names, customer relationships, and so forth including those for which values had never been developed. These values are all added up and compared with the BEV. The difference between the BEV and the sum of the values is called implied goodwill by the FASB.
The difference between the implied goodwill and the recorded goodwill then is the amount of the impairment charge. In other words, the dollar amount of goodwill now to be on the books is the amount calculated as shown previously and which we called the implied goodwill. It must be emphasized that the values of the trade names not recognized before do not get added to the balance sheet. Any new determinations of fair value for any of the assets as determined in Phase II (either more or less than shown on the books) cannot, and do not get reflected on the books. The exercise is carried out for one purpose, and one purpose only, to calculate the implied goodwill. All the other work remains on the working papers and is never reflected on the books of account.
This sounds like a lot of work and it is. A different, but equally good, answer could have been derived by comparing the new BEV with the book value of the reporting unit and simply subtracting that amount from recorded goodwill. We have no idea why the FASB developed such an elaborate requirement, particularly since you cannot take advantage of all the work you have done to develop fair values for all the assets in the reporting unit; put a different way, the company receives no benefit or credit for the increase in value not shown on the existing balance sheet.
The lesson to be learned from this exercise is simple and straightforward, if sometimes difficult to apply in practice. Any time a company overpays for an acquisition it is setting itself up for a future impairment charge. The only way to avoid this is if the acquisition is placed in a reporting unit that is very profitable and for which there is little likelihood of its ever failing the Phase I test. In that situation an overpayment will be buried forever.
Our recommendation, therefore, is that whenever possible new acquisitions should be placed in existing reporting units. Setting up the new business as a separate reporting unit is almost guaranteed to produce a future goodwill impairment charge if the buyer paid too much. Since statistics suggest that 70% of acquisitions do not work out, placing one in an existing profitable reporting unit may at least preclude a subsequent impairment charge. Of course avoiding an impairment charge does not turn a bad acquisition (overpayment) into a successful acquisition.
UNDERSTANDING IMPAIRMENT CHARGES
Many companies try to “spin” the situation when they are forced to take an impairment charge. The explanation when impairments of PP&E or goodwill are taken that “this is a noncash charge” has the unstated implication that noncash charges are immaterial.
Of course when the assets were originally acquired, for cash, nobody said “We just spent cash on this asset” because the outlay was capitalized and did not hit the profit and loss statement (P&L) immediately. The author usually takes with several grains of salt managements who brush off impairment with the noncash charge explanation. The fact remains, there was an original cash outlay and at least from today’s perspective part of that cash outlay was wasted!
In fairness, nobody can foretell the future. Things do not turn out the way they were expected and every reader has had several instances where hindsight suggested that an earlier investment probably was not a good idea. We cannot be paralyzed out of fear of making a mistake. Some investments will turn out better than expected, and others will go down as a “good try.”
The complaint here is the assumption that impairment charges do not matter. They do matter because they are a bright light shining on prior decision making.
Particularly in the area of business combinations, where statistics show that perhaps only 30 to 40% of deals are successful, we see a lot of impairment charges. As valuation specialists we are asked to allocate purchase price of a business combination in accordance with ASC 805 (previously SFAS 141 (r)). Part of our analysis is to look at the projections used in justifying the purchase, compare the projections with the purchase price, and calculate an internal rate of return (IRR).
Often we find very low IRR which is an indication that perhaps our client, the acquirer, overpaid for the acquisition. When two or three years later the company has to take an impairment charge to write down—or even totally write off—the goodwill, the message should be crystal clear: “Things did not work out the way we anticipated. With hindsight we made a mistake and overpaid.”
Instead, the company’s public relations gurus put a “spin” on the situation and imply (perhaps not in so many words) “We were simply a victim of circumstances. Anyone else in the same situation would have done the same thing.”
From our perspective, an impairment charge is recognition of a past mistake. Admit it, and go on. Do not pretend that noncash charges do not matter. They do matter because cash spent on a bad acquisition, or an overpayment for a good acquisition, is gone forever.
Mistakes will continue to be made. Just do not pretend that they are irrelevant.
SUMMARY
Any time actual operating losses occur unexpectedly, or the future outlook calls for operating losses, specific impairment tests should be made, if for no other reason than to demonstrate that internal controls are effective.
Experience with impairment testing also shows that there are relatively few impairment charges associated with PP&E. Intangible assets acquired in a business combination often must be adjusted downward, related in large part to the fact that many mergers involve excessive payments by the buyer. But for PP&E, acquired in the normal course of business and being used for the purpose for which they were originally acquired, impairment charges are rare.
On the other side of the ledger, goodwill impairment charges are fairly frequent, representing one of two situations:
1. Initial overpayment
2. Subsequent adverse economic conditions
The FASB instituted the undiscounted future cash flow test in order to minimize such impairment charges, and they succeeded. Because the estimation of future cash flows associated with a group of operating assets involves significant management judgment, both of sales, and of costs, in addition it is safe to say that the only actual charges occur when management is willing to take the hit. Not surprisingly, when the outlook is bleak, and shareholders and creditors know this, an impairment charge is often disregarded by analysts. At the same time, following the charge, future operations will not be burdened with as high depreciation charges.
But goodwill impairment charges are quite different and should be viewed by management, boards, and analysts as recognition of past mistakes. But as the saying goes, “mistakes happen.”
NOTE
1 The author was a member of the Task Force, which developed the practice aid.
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